Howard Marks’ (Oaktree) latest quarterly letter made big waves in the investing and crypto communities. We’re going to look at Howard’s comments and the comments of his fellow value investors who helped shape his opinions in order to watch the thought process of these old school value investors over time.

Below is Howard Marks first letter to address Digital Currencies. This first letter largely disparages bitcoin and cryptocurrency in general as a fad/bubble.

Maybe I’m just a dinosaur, too technologically backward to appreciate the greatness of digital currency. But it is my firm view that the ability of these things to gain acceptance is just one more proof of the prevalence today of financial naiveté, willing risk-taking and wishful thinking.

In my view, digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none beyond what people will pay for it. But this isn’t the first time. The same description can be applied to the Tulip mania that peaked in 1637, the South Sea Bubble (1720) and the Internet Bubble (1999-2000).

Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future.

Now, here’s his second letter responding to the controversy of his first remarks. He clarifies some thoughts with the help of Murray Stahl and Steven Bregman of Horizon Kinetics.

In the memo I talked about Bitcoin as an investment asset that should have a value that can be appraised. While its fans tell me this isn’t the right way to view it, I note that in their February “Bitcoin Review,” even Steven and Murray called it “a new asset class.” I think this is the weakest claim being made about Bitcoin. As I said in the memo, “it’s not real” – there is no intrinsic value behind it.

What Bitcoin partisans have told me subsequently is that Bitcoin should be thought of as a currency – a medium of exchange – not an investment asset. Given that the evolution of Bitcoin is so topical, I think further discussion is in order. To start, I’m going to present the case for it as a currency. What are the characteristics of a currency?

Most importantly, it’s something that people agree can be used as legal tender (to buy things and pay debts), used as a store of value, and exchanged for other currencies.

Currencies generally are created by governments. However, there have been exceptions: banks issued their own currencies in our nation’s first century, and it can be argued that the “Green Stamps” of my childhood, and airline miles today, have a lot in common with currencies.

For a long time currencies were backed by (and exchangeable for) gold or silver, but that’s no longer the case. The truth is, there’s nothing behind currencies these days other than their issuing governments’ “full faith and credit.” But what do they promise? New currencies are sometimes created out of thin air (like the euro, which wasn’t legal tender sixteen years ago), and sometimes they’re devalued.

Currencies change in value relative to each other, in theory based on differential purchasing power, and in practice based on changes in supply and demand (which can stem, among other things, from changes in purchasing power).Bitcoin fans argue that it qualifies as a currency under these criteria: most importantly, it’s something that parties can agree to accept as legal tender and a store of value. That actually seems right. When I first responded to comments on the memo – even before my recent enlightenment – I found myself admitting that much of the criticism I had leveled at Bitcoin is applicable to the dollar as well. Whereas I said Bitcoin “isn’t real” because it has no intrinsic or underlying value, that’s certainly true of the dollar and other fiat currencies: there’s nothing behind them either. You can no longer exchange them for gold (and what is gold, anyway? But that’s another subject). In fact, government- issued fiat currencies are accorded value only because of a government edict. Why, the fans of Bitcoin ask, is such an edict superior to an agreement among people to accept a non-government-issued currency? Fiat currencies have value simply because of faith in the governments that issue them. If enough people believe in it, why can’t faith in Bitcoin suffice? If you consider the properties of fiat currencies, these are darn good questions.

It sounds like Howard is seeing the light, but struggling a bit with the implications of technologists creating currency out of thin air.

Murray Stahl is the Chairman of Horizon Kinetics LLC and investment holding company FRMO Corp (ticker FRMO) which is a Berkshire Hathaway-style publicly traded investment vehicle.

Horizon Kinetics is a well-known value shop in New York, and the first value-oriented hedge fund to publish research on bitcoin and blockchain technologies. I’m sure many people snickered when they started publishing – but they’ve obviously been huge winners in the space and deserve credit for their foresight.

This first excerpt is from FRMO Corp as they made their initial investments in 2016. They put some money into the venture rounds of DCG and they established $50,000-per-client position limits for crypto investments. They moved into the market very cautiously. Below is their discussion of investing in Digital Currency Group:

This investment is our first venture into the realm of cryptocurrencies. Modern computer technology makes possible the creation of non-fiat currencies. Throughout history, there have been many currencies not issued by governments. Gold and silver are effectively non-fiat currencies. Tobacco leaves were used as currency in Colonial America. Even sea shells have been used as currency.

In the modern world, governments have had a monopoly on currency issuance. As a generalization, governments have frequently abused this privilege and have undertaken actions that severely diminish the value of currencies. The interest in gold as an investment is derived in part from the memory of government engineered currency depreciation. It has happened in recent memory in Argentina and Brazil. It happens in a much more organized way in the case of the Indian rupee. We believe that it will continue to happen. If this supposition is true, then cryptocurrencies should emerge as a very important asset class.

Among the Digital Currency Group’s (“DCG”) assets, it owns Grayscale, which operates the Bitcoin Investment Trust (symbol: GBTC). DCG operates Genesis, which is a cryptocurrency trading firm. It also operates CoinDesk, which is a cryptocurrency news and research company. DCG also takes minority positions in a variety of cryptocurrency-related companies. One of these is Bitpay, which is a bitcoin payment service provider. Another is Elliptic, which identifies illegal activity on the bitcoin blockchain. Another investment is in Coinbase which, among other offerings, provides insured electronic wallet services.

We regard FRMO’s position in DCG as a venture capital investment. It certainly involves risk, which explains our hitherto small commitment. Nevertheless, we are paying very close attention to developments in the cryptocurrency realm. If it is genuinely the intention of governments to engineer a zero rate of compensation on short-term fixed income and then engineer some degree of inflation, essentially guaranteeing a negative real return, the investors of the world will eventually seek a stable value solution.

Considerations of space and reader fatigue make it impossible to fully explain the benefits of non- fiat fixed-supply currencies. We expect to publish research on this subject in the future. At this juncture, perhaps it is sufficient to paraphrase Oscar Wilde by stating that if this is the way that governments treat their investors, they don’t deserve to have any.

And watch their thoughts evolve in 2017. Still tentative, but thinking about how big it could get:

Cryptocurrency is a digital asset that uses cryptology to make transactions secure. It is decentralized insofar as the creation of new units of currency is fixed via an algorithm, and it is outside the control of central banks. The fact that the currency is digital is not an innovation. Most people already use digital assets. Apple Pay or Pay Pal are more sophisticated versions of digital assets. The technical innovation is that cryptocurrency uses a distributed ledger as opposed to a centralized ledger used by banks. Every node in the system of a distributed ledger has a copy of that ledger, so that corruption of the system would necessitate corruption of a vast number of ledgers simultaneously. The ledger cannot be corrupted without gaining access to encrypted private keys. Each participant or account in a distributed ledger has a different set of encrypted private keys. Of course, a private key can be stolen; however, that theft would be a localized event. Corruption of the system would require the theft of possibly millions of private keys all stored in different locations unknown to the potential thieves. Even then, the thief must act quickly and without the knowledge of the intended victim, since the victim could always transfer the digital asset to a newly created private key if actions is taken quickly. This system is entirely different from and inherently far more secure than the central databases currently used by banks.

Yet, from an investment perspective, this characteristic is not necessarily an interesting feature. All of the code is open source and imitation is invited. From an investment perspective, the innovation is that issuance, or supply, can be fixed. In the case of bitcoin, for example, there will not be more than 21 million units created, and this figure should be reached in the year 2140. As of this writing, there are in existence about 16,519,000 bitcoin.

A currency with fixed issuance cannot be debased by a central bank. The idea that private money could compete with fiat money is not new. In fact, it was proposed by Friedrich Hayek in a 1976 book entitled The Denationalization of Money. He suggested that the problem with private money as opposed to government issued fiat money is one of trust. The public must believe that the private issuers of money will not abuse the power of issuance, that there will be a fixed and verifiable sum of money and no more. Given the 1976 technology, this was not readily achievable. Given blockchain technology, it is easily achieved.

At the moment, most people do not accept the legitimacy of private non-fiat money; however, cryptocurrency was recently made legal tender in Japan. Thus, the possibility exists that a cryptocurrency like bitcoin could become a parallel currency to the fiat currency. Merely as an exercise, to understand the appreciation potential, let us assume that bitcoin becomes a parallel currency to the dollar in the U.S. The U.S. supply of money, known as M2, is currently about $13.17 trillion. The market capitalization of bitcoin is about $67.72 billion. Under the no arbitrage rule, if bitcoin were the functional equivalent of fiat money, one might be tempted to say that it should have the same value as fiat money. In this case, it implies appreciation of 194x, without any allowance for the fact that U.S. M2 is constantly increasing. Of course, bitcoin is a worldwide currency, so consideration would need to be given to the M2 of all the other nations of the world. For instance, Japanese M2 is about $9.2 trillion. The European Union, or Eurozone, M2 is about $10.84 trillion. Using Japan alone, the possible coefficient of expansion is 135.9x.

It must be noted that the entire cryptocurrency project might be a total failure; however, if it is not a failure, one can now see its return potential.

I’m writing about this because these are some of the smartest macro/value investors in the world. I like to observe their moves into this new novel space and see how they are thinking about it compared to the more technology-focused investors. Brick by brick, and with appropriate caution, a strong case in being made for crypto by some of the smartest minds in the world – including value investors.

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